LONDON, March 20 (Reuters) - Some hedge funds have begun quietly increasing their bets against Hungarian sovereign bonds in the belief that the yields don't properly reflect the country's political and economic outlook.
The amount of Hungarian sovereign bonds out on loan - an indicator of short-selling by funds anticipating a drop in price - has risen sharply in recent weeks, data shows, while short interest in some other leading east European economies has fallen.
Economics and politics are informing these hedge funds' thinking on Hungary, central Europe's most indebted nation on the basis of its public debt of around 79 percent of GDP.
Hungary's economy shrank 2.7 percent year-on-year in the fourth quarter. Many of its firms and citizens are shackled with costly foreign currency loans.
Changes to Hungary's constitution have drawn criticism from the European Union, United States and human rights groups, who say Prime Minister Viktor Orban is undermining democracy - an accusation the government denies. Orban has also been criticised for appointing a close associate as governor of the central bank.
Some hedge fund managers think yields on Hungarian sovereigns are too low - the 15-year yield for instance stood at 6.8 percent on Wednesday, below 7.5 percent for emerging market peers Russia or South Africa.
The managers believe such yields don't fully reflect the economic and political fundamentals in Hungary.
And as Cyprus's 10 billion euro ($13 billion) bailout reignites fears over Europe's debt burden, some hedge funds are betting the investors who rushed into Hungary bonds last year are overlooking a number of negative factors.
"I still don't understand why bond yields are trading so tight (low), given the current situation," said Steven Mitra, partner and senior portfolio manager at hedge fund firm LNG Capital, who last week put on a "short" position on Hungarian sovereign bonds, betting on a price fall.
"The 2018 and 2020 bonds, yielding 4.5 to 5 percent, are the sweet spot to short. It's a very cheap short to put on given the current risk profile of the country."
Hungary defends its economic prospects and domestic policies.
Foreign Minister Janos Martonyi said the country had suffered from a "bad press" and said the government was actually extending the powers of the constitutional court.
"I'm absolutely convinced this is vastly exaggerated and distorted ... I'd encourage everyone first to read through the text," he said in a telephone interview, referring to proposed constitutional changes.
Martonyi told Reuters the central bank is "completely independent" while "a substantial part" of the foreign currency mortgage situation had been resolved. "The general financials of the country are very good," he said.
Hungary's debt was cut to "junk" status by all three major rating agencies just over a year ago as growth dried up and investors balked at government policies including Europe's highest bank tax, windfall taxes on energy and telecoms firms and the effective nationalisation of private pension funds.
In December Fitch improved its credit-rating outlook for Hungary to stable from negative, recognising government efforts to cut the budget deficit, but Moody's said in February it was keeping its "junk" rating of Ba1 on Hungary's debt and maintaining a negative outlook, blaming the country's weak growth outlook.
Hungary has one of the highest foreign ownership levels in the bond markets of any emerging market at around 45 percent. The country last month raised $3.25 billion after a near two-year absence from international debt markets.
Investors are still buying shorter Hungarian debt on expectations for further interest rate cuts by the central bank, and all the government debt auctions have gone smoothly for over a year now.
Yet data from Lipper shows that six out of the seven bond funds above $3 billion in size that had disclosed holdings in Hungary had reduced their holdings since June.
And recent weeks have seen a rise in short-selling of Hungary bonds, or betting on a lower price by borrowing securities, then selling them with the aim of buying them back at a cheaper price.
The amount of Hungarian sovereign bonds out on loan - an indicator of short-selling - jumped by 55 percent since Feb. 14 to hit $567 million on Monday, the highest level since early November, according to data group Markit.
By comparison, bonds out on loan are down 22 percent for the Czech Republic, down 15 percent for Slovakia and down 3 percent for Ukraine. For Poland, bonds out on loan are up 15 percent in the same period.
The amount of Hungarian bonds out on loan had been fairly steady above $500 million last summer, before rising as high as $700 million in October then dropping back, as hedge funds cut their bets in the face of an investor rush for riskier assets on hopes Europe's debt crisis would be defused.
Bonds out on loan briefly spiked above $1.5 billion at the start of last year, although they were below today's levels through 2009 and 2010.
Foreigners' total forint-denominated bond holdings were worth some 4.8 trillion forints ($20 billion).
"On the short side, we're negative on Hungary. The long end of the curve looks mispriced. We don't understand what's keeping ... yields where they are, apart from the frothiness of emerging market inflows," said Sohail Malik, lead portfolio manager of ECM Asset Management's Special Situations fund.
ECM manages around $9.5 billion in assets.
Some funds have also been betting against the forint, which hit a 14-month low against the euro on Monday, said one investor in hedge funds.
"Boy, do Hungary and its CEE (central and eastern European) neighbours need to rebalance," said Savvas Savouri, chief economist at hedge fund firm Toscafund. "After all, their customers and funders mainly come from the euro zone and that place is in a deepening mess."
Savouri said Toscafund does not trade currencies but declined to comment further on its positions.
"As for Hungarian bonds, well let's just say they flatter to deceive ... Their present yield does not price in adequate currency risk or indeed growth disappointment."